As you build your real estate investing portfolio, you will have your eyes opened to a whole new world of wealth building strategies and opportunities that most will never experience.
One tool or strategy that investors use is a 1031 exchange or a like-kind exchange. The basic concept of this is using the proceeds realized from the sale of an asset toward the purchase a new like-kind asset. This strategy allows all the capital gains from the sale to be tax deferred. If you are wondering where the 1031 comes from, it is the section number of IRS code where this exists.
Besides reducing your tax liability, why would an investor use this strategy? The answer is to allow them to trade up their properties without penalty. Many investors begin by purchasing single family residences in lower-economic areas, which often present unique challenges and lower ROI. Using the 1031 exchange, an investor could sell this property, purchase in a different neighborhood or a property that is likely lower-maintenance, and keep the IRS away.
So how does it work? You must sell your investment property and use the capital gains on a new property of equal or higher value. This will defer the taxes until the new property is sold, unless you utilize the 1031 exchange again. Here are a few of the finer details:
Like-kind property exchange has to occur. Meaning the new property being purchased has to be of equal or higher value and it has to be used on the same type of property. You cannot swap industrial equipment for a duplex.
The new property has to be selected within 45 days.
All gains from the sale must be used on the new property within 180 days of sale.
The like kind rule has to be used, meaning real property has to be exchanged for real property, not personal.
The 1031 can only be used on investment, commercial, personal or trade properties. It cannot be used on personal residences.
Let us look at an example of this might work.
An investor has a duplex they purchased five years ago for $100,000 and they sell it for $200,000. If the investor takes the $200,000 and purchases another property with all the money, say on it a 6-plex, and does it through a 1031 exchange, the investor would not have to pay any capital gains taxes. Theoretically, they have improved their investment property value and cash flow, while not having to pay taxes.